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6 November

06 November 2015

Investment markets and key developments over the past week

Global shares saw solid gains over the last week helped by good economic data, albeit with rising expectations of a US Federal Reserve (Fed) rate hike in December constraining the gains. Over the week US shares rose 1%, Eurozone shares gained 1.5%, Japanese shares rose 0.9% and Chinese shares gained 6.1%. In fact, Chinese shares are now up 20% up from their August low. Australian shares lost 0.5% though, dragged down by banks and mining stocks. The US$ also broke higher, putting pressure on commodity prices with oil down 4.5% and copper losing 3.2%. As a result, the A$ fell, particularly in response to strong US jobs data for October.

A “good” versus a “bad” Fed hike. The past week saw Fed Chair Yellen reiterate the message from the Fed’s last post-meeting statement that a December rate hike is a “live possibility” if economic data supports its relatively upbeat expectations regarding the economy and inflation. The key for investors is to recognise there is a difference between a “good Fed hike” (where rates are raised against a backdrop of solid economic news and receding worries about the US/global growth and inflation outlook) and a “bad Fed hike” (where rates are raised against a backdrop of global and US growth worries, probably made worse by a rising US$ adversely affecting commodities and emerging market currencies). Either way, a December rate hike would likely see market wobbles but they would be short lived with a “good hike” and longer-lived with a “bad hike” as the latter would be seen as a policy error. The key is that, by making a hike dependent on receiving information consistent with its upbeat economic view, the Fed should be unlikely to embark on a “bad hike”.

Against this background, strong US jobs data for October supports the case for a December Fed rate hike and adds to confidence it will be a “good hike”. The October jobs report was strong all round, with payrolls up 271,000, unemployment falling to 5% and hourly earnings rising 0.4% month-on-month, pushing the year on year growth rate to 2.5%. As a result it’s increasingly looking like the strong US jobs market is starting to push wages growth higher, albeit from a low base. This is all consistent with the Fed’s requirement for a rate hike, i.e. that there be further improvement in the US jobs market and more confidence that inflation will start to head back up to the Fed’s target. Of course, it’s dangerous to read too much into one month’s worth of jobs data and there is a lot more information to flow before the Fed’s December 15-16 meeting, but right now the probability of a Fed hike next month has risen to around 70%. To the extent that the jobs data adds to optimism regarding the US economy, it also adds to confidence that a move in December will be a “good Fed hike” as opposed to a “bad hike”. The US share market took it that way on Friday, with the boost to optimism from the jobs data overcoming an initial 0.8% decline in shares on Fed fears, enabling the S&P 500 to end flat and the Dow and Nasdaq up. There is a way to go yet though and the main thing to watch is whether a rising US$ reignites worries about the emerging world and weaker commodity prices, which in turn then serves to ambush the Fed. When the Fed does start moving, with growth running at just 2% and the US economy far from any capacity constraints, it’s likely to be a very gradual rate hiking cycle.

RBA still content on interest rates, but adopts an easing bias. While the RBA has signalled it remains content with current interest rate settings, it has adopted an easing bias, with RBA Governor Steven’s noting that, were there to be a change in monetary policy “in the near-term, it would almost certainly be an easing, not a tightening”. The RBA’s easing bias is reinforced by the downwards revision to the RBA’s inflation forecasts in its Statement on Monetary Policy. Although the RBA is sounding a bit more upbeat on the economy, it’s noteworthy that yet again it revised down its GDP growth forecast for this year to 2.25% from 2.5% in August, which in turn was down from a mid-point of 2.75% in February. Its 2017 growth forecasts were also shaved.

While the RBA is clearly in no rush to move on rates, so a December cut may be premature, we expect the RBA to act on its easing bias sometime in the months ahead as: bank mortgage rate hikes, which have now spread to the smaller banks, are likely to weigh on retail sales in the run-up to Christmas; the non-mining investment outlook remains poor; peaking building approvals point to a peak in the contribution to growth from home construction next year; El Nino related drought risks are posing an additional threat to growth; the terms of trade are still sliding; the A$ remains too high; and inflation is likely to remain below target.

It’s worth noting that I am not in the bearish camp on the Australian economy. It has been rebalancing nicely, but I do see it needing more help to continue doing so as the mining investment downturn continues. It is noteworthy that since the RBA started cutting interest rates four years ago we have seen several occasions where it has expressed reluctance to ease again, only to ultimately resume easing.

Regardless of whether the RBA holds or cuts, interest rates look like remaining at very low levels for a long time as we are only about half-way through the mining investment downturn. As a result, higher yield assets like Australian shares and commercial property are likely to remain attractive for investors looking for decent income flows. The gap between the dividend yield on Australian shares, grossed up for franking credits and 12-month term deposit rates, remains about as wide as it has been since the global financial crisis. As we have seen in recent years “search for yield” investor demand is likely to remain a source of support for the Australian share market, in between the periodic scares about growth, bank capital raisings, etc.

Source: RBA, AMP Capital

Major global economic events and implications

In terms of global growth worries, it’s notable there has been some good news over the last week, with October manufacturing and services conditions PMIs (as published by Markit) mostly seeing decent gains in the US, Europe, Japan and China. While monthly data can be volatile, it could be a sign that the September quarter soft patch in global business surveys, that helped drive growth worries through the quarter, may have come to an end.

US September quarter earnings have come in better than expected but still down slightly. 88% of S&P 500 companies have now reported, with 73% beating earnings estimates. Consensus earnings expectations for the year to the September quarter have improved from -6.3% three weeks ago to -2.8%. Revenue has been disappointing though, with only 44% of companies beating on sales, as the strong US$ and falling oil price have weighed negatively. These drags will recede though if the US$ and oil price stabilise. German factory orders fell for the third month in a row in September, despite okay readings for the German manufacturing PMI, suggesting a bounce back soon.

German factory orders fell for the third month in a row in September, despite okay readings for the German manufacturing PMI, suggesting a bounce back soon.

It looks like there is a good chance that the IMF will include the Renminbi in its basket of Special Drawing Right (SDR) currencies (currently the US$, euro, British pound and yen) as early as late this month. While inclusion in the rather archaic SDR supplementary foreign exchange reserve assets is unlikely to have a major impact on global financial markets, or Chinese economic prospects, it will symbolically help boost the Renminbi’s global status as a reserve currency and China’s importance in global financial markets.

Australian economic events and implications

Australian economic data releases were a mixed bag. Retail sales are continuing to motor along with okay growth, albeit being helped by weak pricing. Continued growth in retail sales volumes, and a strong contribution from trade, looks like underpinning September quarter GDP growth at a reasonable rate. On the other hand though (starting to sound like an economist here!) the AIG’s manufacturing and services conditions PMIs fell in October to around 50 or below, pointing to a renewed weakening in business conditions, and building approvals look increasingly like they have peaked, pointing to a limit in the contribution to growth from home construction in the first half of next year. CoreLogic RP Data for October shows further evidence of a cooling in the housing market and the October TD Securities Inflation Gauge shows inflation remains below target.

What to watch over the next week?

In the US, expect an improvement in October retail sales growth and benign producer price inflation (both Friday). Data will also be released for job openings and consumer confidence.

Chinese economic data for October is expected to show continued robust growth in retail sales at 10.9% year-on-year a slight pick-up in industrial production growth to 5.8% yoy (both due Wednesday), a fall back in credit growth after a surge in September and a fall in consumer price inflation (Tuesday) to 1.5% yoy.

In Australia, housing finance data (Tuesday) is expected to show a slowing, led by investors. The NAB business survey (Tuesday) and the Westpac consumer confidence survey (Wednesday) will be watched for improvements in confidence and labour force data (Thursday) is expected to show a 10,000 bounce in jobs but with unemployment remaining at 6.2%.

Outlook for markets

After a strong recovery in shares from their September lows, it’s likely we will see a pause or modest pull back in share markets in the weeks ahead. US shares in particular are now looking a bit overbought. Some complacency has crept back in and worries about a Fed driven rise in the US$ and its flow on to commodities and emerging market currencies look like they could re-emerge.

However, following a pause or correction, share markets are likely to see the normal “Santa Claus” rally into year-end and the broad trend in shares is likely to remain up. Shares are cheap relative to bonds; monetary conditions are set to remain easy and the Fed is unlikely to do anything to threaten global growth; and this in turn should help see the global economic recovery continue. As such, share markets are likely back in a broad rising trend. This includes the Australian share market, where we continue to see the ASX 200 rising to around 5500 by year end.

Low bond yields point to soft medium term returns from bonds, although government bonds remain a great portfolio diversifier.

The broad trend in the A$ is likely to remain down as the Fed is likely to raise interest rates sometime in the next six months, whereas the RBA is more likely to cut rates again and the trend in commodity prices remains down. This is expected to see the A$ fall to US$0.60 in the next year or so.